GENTLEMEN PREFER BONDS

(A piece I had written for an investor magazine)

The economic outlook seems cloudy. Not so cloudy that we are in the dumps, but just the fact that double digit growth in GDP now looks like a tough ask. Everyone seems to be now on a seven to eight percent band for the immediate couple of years. What this means is that our equity markets are likely to remain range-bound for longer than we think. Whilst we could see some extreme volatility in the near term based on funds flows from the FII universe, the upside seems to be kind of capped.
Of the many worries, interest rate worry seems to be one that is dampening corporate profit growth. We are seeing a large number of companies offering rates in excess of eleven percent per annum for long dated borrowings. To me, this is perhaps a good opportunity. I look at it this way. The corporate is raising money at over eleven percent for ten years. In essence, it gives me a great opportunity to lock in some money at this kind of a rate. Of course, I will go wrong if inflation and interest rates keep rising significantly. Is that likely? Perhaps there would be one more round of misguided interest rate hike by the Reserve Bank of India. After that there has to be a lull and hopefully a decline in interest rates. This lowering or falling in interest rates will not happen only if we see economic growth of India slipping dramatically over the next few years. I think that India will grow at over seven percent, irrespective of politics. About double digits, I am not sure. If this has to happen, we need lower interest rates.
So, coming back to these bonds and other long dated debt instruments, it is great to put in some money at this juncture. There is a twofold gain here:

i) If interest rates remain high, equity is going to be in the dumps. We lock in a sure and reasonably attractive yield on the debt instrument (above 11% p.a. for ten years or so, without any re-investment risk);
ii) If interest rates fall, then the values of the papers we buy now increase. For instance, in a ten year bond, a quarter percent decline in interest rates would mean a capital appreciation of over one rupee in the debt paper that we buy today. (When interest rates fall, the price of bonds go up and vice versa)
I think debt may be the best place over the next six months to a year, for investors.
Bonds are better in one another way. Many of us are used to the Fixed Maturity Plans (FMP) of the mutual funds. Post June 30th, the change in the tax regime will rob the tax attractiveness of FMP. Bonds would be better. The other thing is that in most of the bonds, there is no tax deducted at source (TDS), which helps with a better cash flow.
Bank deposits are also attractive, but give a lower return than bonds. Another thing is that we cannot get to lock in the rate of interest for ten years in bank deposits.
Whilst talking about bonds, many people will tell you that it is ‘secured’. This means absolutely nothing so far as timely repayment is concerned. We have hardly seen a company having any assets left, when it comes to a stage of default. Rather, let us remain focused on the quality of paper we buy. Good names and a high credit rating are important whilst buying bonds, unless one is comfortable with a higher risk. The key is to be focused on risk, since a bond could be for ten years, and in ten years, a lot can happen.
The bonds can be held in demat form, which makes it easier to handle. Interest is generally payable at half yearly intervals.
Bonds are generally listed and tradable. There is a secondary market for this. In an emergency, one can always sell it through the secondary market. And unlike equity, the price changes in the bonds are not extreme. A full one percentage change in interest rate would equate to a change of around five rupees, on a ten year bond with a coupon of eleven percent. So, the risk to capital is modest, should one have to exit before maturity.
There will be many papers available and it would be good to pick up some in the next two to three months. For, when the interest rates start moving down, the yields on these bonds will start to fall, correspondingly.